AGGREGATE DEMAND CURVE: A graphical representation of the relation between aggregate expenditures on real production and the price level, holding all ceteris paribus aggregate demand determinants constant. The aggregate demand, or AD, curve is one side of the graphical presentation of the aggregate market. The other side is occupied by the aggregate supply curve (which is actually two curves, the long-run aggregate supply curve and the short-run aggregate supply curve). The negative slope of the aggregate demand curve captures the inverse relation between aggregate expenditures on real production and the price level. This negative slope is attributable to the interest-rate effect, real-balance effect, and net-export effect.

A shock to the short-run aggregate market caused by a decrease in aggregate demand, resulting in and illustrated by a leftward shift of the aggregate demand curve. A decrease in aggregate demand in the short-run aggregate market results in a decrease in the price level and a decrease in real production. The level of real production resulting from the shock can be greater or less than full-employment real production.

While a wide range of specific aggregate demand determinants can cause a decrease in the four expenditures and thus a decrease in aggregate demand, the following rank among the more important:

Expectations of lower inflation rates in the near future that entices the household sector to decrease consumption expenditures in the present awaiting lower future prices.

A rise in interest rates associated with natural business-cycle activity or specifically induced by contractionary monetary policy from the Federal Reserve System that induces the household and business sectors to decrease consumption and investment expenditures.

Contractions in other nations that induce the foreign sector to decrease the purchase of domestic exports, thus decreasing net exports.

A decrease in purchases and/or an increase taxes by the federal government resulting from contractionary fiscal policy.

A decrease in state or local government purchases, and/or an increase in state or local taxes.

Demand DecreaseShort-Run Aggregate Market

The short-run aggregate market presented in the graph to the right sets the stage for analyzing the effect of a decrease in aggregate demand resulting from a change in any aggregate demand determinant. The vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The negatively-sloped curve, labeled AD, is the aggregate demand curve and the positively-sloped curve, labeled SRAS, is the short-run aggregate supply curve. The current short-run equilibrium, found at the intersection of the AD and SRAS curves, is a price level of 10 and real production of $100 billion.

Consider what happens to this short-run aggregate market with a decrease in aggregate demand. Suppose, for example, that after several years of business-cycle expansion, the household sector grows increasingly concerned that a contraction is on the horizon. Suspecting that contraction is about to begin, they spend less and save more, preparing for the troubled times ahead. This decline in consumer confidence prompts the household sector to decrease consumption expenditures. The result of this action is a leftward shift of the AD curve. Click the [AD Decrease] button to illustrate.

The result of this leftward AD curve shift is that a new short-run equilibrium is achieved at a lower price level (9) and a smaller amount of real production ($90 billion). This result is comparable to that for a standard market. A decrease in market demand results in a lower equilibrium price and a smaller equilibrium quantity. The key difference, of course, is that this "market" is the aggregate product market for the entire economy and not the market for a specific good.

A comparative static analysis of the original equilibrium and the new equilibrium is useful and important. However, it is also instructive to dissect the adjustment process.

First, the AD curve shifts leftward due to the decrease in consumption induced by a decline in consumer confidence. This decline in aggregate demand creates an imbalance in the aggregate market. At the existing price level (which has NOT yet changed), producers are willing and able to sell $100 billion worth of real production. Buyers, however, are now willing and able to purchase less, something like $80 billion worth of real production. This creates economy-wide product market surpluses.

Second, motivated by a build-up of inventories created by economy-wide product market surpluses, producers decrease production. In the short run they do so by reducing the employment of resources, especially labor. While resource prices do NOT decline enough to maintain full employment, the reduction in real production does lead to a decline in production cost which causes product prices and the price level to fall.

Third, with the falling price level, buyers are induced to increase aggregate expenditures. The combination of producers decreasing real production and buyers increasing aggregate expenditures act to reduce the existing economy-wide product market surpluses. In fact, as long as economy-wide product market surpluses persist producers decrease production, which causes the price level to fall, which increases aggregate expenditures. Eventually the falling real production and rising aggregate expenditures meet at the new short-run equilibrium price level of 9 and real production of $90 billion.

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